Friday, March 30, 2012

How I Would Overhaul the U.S. Tax Code - Part II: Current Problems in the System

The problems of the U.S. Tax Code are almost innumerable, but I will describe only the most inimical flaws that this proposed overhaul will address. These can be categorized broadly in three groups: problems of unfairness, problems of inefficiency and problems of complexity.

The tax code is unfair when it derives revenue in a needlessly regressive manner as in the case of the funding source for Social Security and Medicare. The FICA Tax that raises revenue for those programs is flat and thus by definition regressive. An individual earning $20,000 annually is in the same income bracket as a person earning $90,000 in the same year as far as the FICA tax is concerned. To make matters worse, only the first $106,800 of wages is subject to Social Security portion of the tax while investment income is not subject to the tax at all. This means that for three fourths of Americans, the FICA tax represents a majority of their tax liability. But for the wealthiest people in the country, the FICA tax is a minuscule part of their bill.

The federal income tax is more progressive in structure than the FICA tax, but it has become dramatically less progressive in recent decades. At the same time as the richest Americans became ever wealthier while every other income group stagnated, the federal government has been effectively providing a regular boost to the aftertax income of the top income bracket. Thus the government has only been exacerbating an already pernicious problem of rapidly growing income inequality.

In addition to its dwindling vertical equity, the federal income tax is also economically inefficient. Conservatives of various stripes regularly make an argument against the federal income tax on this basis. But some progressives have articulated the point as well, with Robert Frank arguing in the liberal American Prospect magazine that “taxes do more than pay for public services. Taxing any activity both generates revenue and discourages the activity.” With this in mind, he reasons that we should not tax work or income, as both the federal income tax and the FICA tax do, because we do not want to discourage either of those activities. It is highly inefficient for governments to discourage desirable economic activities through taxes, and can only be justified if there are no alternative mechanisms for raising necessary revenue. However, there are alternatives.

Finally, a growing chorus of voices has been calling for root-and-branch tax reform simply because the code has grown so complex in the past quarter century since the last major revision. Both parties abuse tax expenditures as a way to favor their political priorities without adding any new spending to the budget even though the fiscal effect is usually the same and tax expenditures are often far less economically efficient. Coupled with the intense influence of special interest groups who constantly lobby for special tax privileges and the like, the tax code seems to inevitably turn to swiss cheese within a few decades of each major reform. Perhaps this is unavoidable, but the need for fairly regular reform does give the country an opportunity to seriously reconsider its tax system every few decades. Instead of squandering this opportunity by only eliminating loopholes and adjusting rates while keeping suboptimal revenue sources in place, we should embrace the chance to use an overhaul to creatively address our nation’s biggest challenges.